Chapter 2: Qualitative characteristics of useful financial information
The Framework states that the types of information likely to be most useful to providers of capital are identified by various qualitative characteristics, comprising:
two ‘fundamental qualitative characteristics’:
– relevance; and
– faithful representation; supplemented by
four ‘enhancing qualitative characteristics’:
– timeliness; and
Chapter 3 of the Framework also notes the role of cost as a ‘pervasive constraint’ on a reporting entity’s ability to provide useful financial information.
Monetary amounts in financial reports will not always be observed directly and must instead be estimated; in such cases measurement uncertainty arises. The use of reasonable estimates is an essential part of the preparation of financial information and does not undermine the usefulness of the information if the estimates are clearly and accurately described and explained. Even a high level of measurement uncertainty does not necessarily prevent such an estimate from providing useful information.
Financial reports provide information about the reporting entity’s economic resources, claims against the reporting entity and the effects of transactions and other events and conditions that change those resources and claims (collectively referred to in the Framework as ‘the economic phenomena’). Some financial reports also include explanatory material about management’s expectations and strategies for the reporting entity, and other types of forward-looking information.
The qualitative characteristics of useful financial information apply to all financial information, whether provided in financial statements or in other ways. All financial information is also subject to a pervasive cost constraint on the reporting entity’s ability to provide useful financial information. However, the considerations in applying the qualitative characteristics and the cost constraint may be different for different types of information. For example, applying them to forward-looking information may be different from applying them to information about existing economic resources and claims and to changes in those resources and claims.
Fundamental qualitative characteristics
In order to be useful, financial information must be relevant and faithfully represent what it purports to represent
Relevance (including materiality)
Relevant financial information is that which is capable of making a difference to the decisions made by users, irrespective of whether some users choose not to take advantage of it or are already aware of it from other sources. Financial information is capable of making a difference in decisions if it has predictive value, confirmatory value or both.
Financial information has predictive value if it can be used as an input to processes employed by users to predict future outcomes. Financial information with predictive value need not itself be a prediction or forecast, but is employed by users in making their own predictions. Financial information has confirmatory value if it confirms or changes previous evaluations.
The predictive value and confirmatory value of financial information are interrelated. For example, information on revenue for the current year can be used both as the basis for predicting revenues in future years, and as a point of comparison with predictions made in prior years of revenue for the current year. The results of those comparisons can help a user to correct and improve the processes that were used to make those previous predictions.
The Framework refers to materiality as ‘an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report’. In other words, information is material (and therefore relevant) if omitting or misstating it could influence the decisions of users of financial information about a specific reporting entity. Because of the specificity of materiality to a particular reporting entity, the Board cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation.
The Framework observes that financial reports represent economic phenomena in words and numbers. To be useful, financial information must not only represent relevant phenomena, but it must also faithfully represent the substance of the phenomena that it purports to represent. In many circumstances, the substance of an economic phenomenon and its legal form are the same. If they are not the same, providing information only about the legal form would not faithfully represent the economic phenomenon.
A perfectly faithful representation would be:
– neutral, and
– free from error.
The Board’s objective is to maximise those qualities to the extent possible, while acknowledging that perfection is seldom, if ever, achievable.
A complete depiction includes all information, including all necessary descriptions and explanations, necessary for a user to understand the phenomenon being depicted. For example, a complete depiction of a group of assets would include, at a minimum:
– a description of the nature of the assets;
– a numerical depiction of the assets; and
– a description of what the numerical depiction represents (for example, historical cost or fair value).
For some items, a complete depiction may also entail explanations of significant facts about the quality and nature of those items, factors and circumstances that might affect their quality and nature, and the process used to determine the numerical depiction.
A neutral depiction is one without bias in the selection or presentation of financial information. A neutral depiction is not slanted, weighted, emphasised, de-emphasised or otherwise manipulated to increase the probability that financial information will be received favourably or unfavourably by users. That is not to imply that neutral information has no purpose or no influence on behaviour. On the contrary, relevant financial information is, by definition, capable of making a difference in users’ decisions.
The Framework has a discussion of the word ‘prudence’, the exercise of which is considered by the Board to support neutrality. The Board considers prudence to be the exercise of caution when making judgements under conditions of uncertainty. This is said to mean that:
– assets and income are not overstated and liabilities and expenses are not understated; but also that
– the exercise of prudence does not allow for the understatement of assets or income or the overstatement of liabilities or expenses.
Such misstatements can lead to the overstatement or understatement of income or expenses in future periods.
This is not, perhaps, a universally accepted view of the meaning of the word prudence – which to many may mean a more cautious approach to recognising gains and assets and a less cautious approach to recognising losses and liabilities.
The Board addresses this by stating that the exercise of prudence does not imply a need for asymmetry, for example, a systematic need for more persuasive evidence to support the recognition of assets or income than the recognition of liabilities or expenses. Such asymmetry is not considered by the Board to be a qualitative characteristic of useful financial information. Nevertheless, particular standards may contain asymmetric requirements if this is a consequence of decisions intended to select the most relevant information that faithfully represents what it purports to represent.
The Framework stresses that the term ‘free from error’ does not necessarily imply that information is accurate in all respects. Rather, information is ‘free from error’ if there are no errors or omissions either in the description of the economic phenomenon being depicted or in the selection or application of the process used to produce the reported information. For example, an estimate of an unobservable price or value cannot be determined to be accurate or inaccurate. However, a representation of that estimate can be faithful if the amount is described clearly and accurately as being an estimate, the nature and limitations of the estimating process are explained, and no errors have been made in selecting and applying an appropriate process for developing the estimate.
Applying the fundamental qualitative characteristics
In order to be useful, information must be both relevant and provide a faithful representation. In the Board’s words ‘neither a faithful representation of an irrelevant phenomenon nor an unfaithful representation of a relevant phenomenon helps users make good decisions’.
The most efficient and effective process for applying the fundamental qualitative characteristics would, subject to the effects of the enhancing qualitative characteristics and the cost constraint below), usually be as follows:
– identify an economic phenomenon, information about which is capable of being useful to users of the reporting entity’s financial information;
– identify the type of information about that phenomenon that would be most relevant; and
– determine whether that information is available and whether it can provide a faithful representation of the economic phenomenon.
If so, the process of satisfying the fundamental qualitative characteristics ends at that point. If not, the process is repeated with the next most relevant type of information.
The Framework notes that, potentially, a trade-off between the fundamental qualitative characteristics may need to be made in order to meet the objective of financial reporting, which is to provide useful information about economic phenomena. This is illustrated by reference to estimation which, as noted at 5 above, is an essential part of the preparation of financial information and does not undermine the usefulness of it. The example given is where the most relevant information about a phenomenon may be a highly uncertain estimate. In some cases, the level of measurement uncertainty involved in making that estimate may be so high that it may be questionable whether the estimate would provide a sufficiently faithful representation of that phenomenon. In some such cases, the most useful information may be the highly uncertain estimate, accompanied by a description of the estimate and an explanation of the uncertainties that affect it. In other such cases, if that information would not provide a sufficiently faithful representation of that phenomenon, the most useful information may include an estimate of another type that is slightly less relevant but is subject to lower measurement uncertainty. In limited circumstances, there may be no estimate that provides useful information. In those limited circumstances, it may be necessary to provide information that does not rely on an estimate.
Enhancing qualitative characteristics
The usefulness of relevant and faithfully represented financial information is enhanced by the characteristics of comparability, verifiability, timeliness and
understandability. These enhancing characteristics may also help determine which of two ways should be used to depict a phenomenon if both are considered equally relevant and faithfully represented.
The Board notes that decisions made by users of financial information involve choices between alternatives, such as selling or holding an investment, or investing in one entity or another. Consequently, information about a reporting entity is more useful if it can be compared with similar information about other entities, and about the same entity for another period or as at another date.
Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items. Unlike the other qualitative characteristics, comparability does not relate to a single item, since – by definition – a comparison requires at least two items. The Board clarifies that, for information to be comparable, like things must look alike and different things must look different, adding that ‘comparability of financial information is not enhanced by making unlike things look alike any more than it is enhanced by making like things look different. Although a single economic phenomenon can be faithfully represented in more than one way, permitting alternative accounting methods for the same economic phenomenon diminishes comparability.
The Framework stresses that consistency (that is, the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities) helps to achieve comparability, but is not the same as comparability. The Board adds that comparability is not the same as uniformity, but without any definition of ‘uniformity’ or clarification of how it differs from comparability. Some degree of comparability is likely to be attained simply by satisfying the fundamental qualitative characteristics.
In other words, a faithful representation of a relevant economic phenomenon by one entity should naturally be comparable with a faithful representation of a similar relevant economic phenomenon by another entity.
Verifiability helps assure users that information faithfully represents the economic phenomena that it purports to depict. Verifiability means that different knowledgeable and independent observers could reach a consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Quantified information need not be a single point estimate to be verifiable. A range of possible amounts and their related probabilities can also be verified.
The Board notes that verification can be direct or indirect. Direct verification means verifying an amount or other representation through direct observation. Indirect verification means checking the inputs to a model, formula or other technique and recalculating the outputs using the same methodology. Some explanations and forward-looking financial information may not be verifiable until a future period, if at all. To help users decide whether to use such information, it would normally be necessary to disclose the assumptions, other factors and circumstances underlying the information, together with the methods of compiling the information.
Timeliness means that information is available to decision-makers in time to be capable of influencing their decisions. Generally, the older the information is the less useful it is. However, some information may continue to be timely long after the end of a reporting period, for example because some users may need to identify and assess trends.
Information is made understandable by classifying, characterising and presenting it clearly and concisely. The Board concedes that some phenomena are so inherently complex and difficult to understand that financial reports might be easier to understand if information about those phenomena were excluded.
However, reports prepared without that information would be incomplete and therefore possibly misleading.
Moreover, financial reports are prepared for users with a reasonable knowledge of business and economic activities who can review and analyse the information diligently. Even such users, however, may need to seek specialist advice in order to understand information about complex economic phenomena.
Applying the enhancing qualitative characteristics
The Framework stresses that, while the enhancing qualitative characteristics should be maximised to the extent possible, they cannot, either individually or as a group, make information useful if that information is irrelevant or does not give a faithful representation.
Applying the enhancing qualitative characteristics is an iterative process that does not follow a prescribed order. Sometimes, one enhancing qualitative characteristic may have to be diminished in order to maximise another. For example, applying a new standard prospectively (that is, with no restatement of prior periods) will reduce comparability in the short term. However, that may be a price worth paying for improved relevance or faithful representation in the longer term. Appropriate disclosures may partially compensate for the lack of comparability.
The cost constraint
The Board acknowledges that cost is a pervasive constraint on the information provided by financial reporting, and that the cost of producing information must be justified by the benefits that it provides. Interestingly, the Board argues that, while there is clearly an explicit cost to the preparers of financial information, the cost is ultimately borne by users, since any cost incurred by the reporting entity reduces the returns earned by users.
In addition, users incur costs not only in analysing and interpreting any information that is provided, but also in obtaining or estimating any information that is not provided.
Relevant and faithfully representative financial information helps users to make decisions with more confidence, resulting in a more efficient functioning of capital markets and a lower cost of capital for the economy as a whole. An individual provider of capital also receives benefits by making more informed decisions. However, it is not possible for general purpose financial reports to provide all information relevant to every user.
In assessing whether the benefits of reporting particular information are likely to justify the cost, the Board seeks information from providers of financial information, users, auditors, academics and others about the expected nature and quantity of the benefits and costs of that standard. In most situations, assessments are based on a combination of quantitative and qualitative information, and will normally be considered in relation to financial reporting generally, and not in relation to individual reporting entities. However, an assessment of costs and benefits will not always justify the same reporting requirements for all entities. Differences may be appropriate because of different sizes of entities, different ways of raising capital (publicly or privately), different needs of users or other factors.